Why is diversification critical in reducing investment portfolio risk?

Diversifying your investment portfolio is essential because this strategy allows you to spread your risk and prepare for the inherent market volatility. Any investment will have its own expected return and expected risk (volatility) profile, and that is valid for stocks, bonds, term deposits, mutual funds, ETFs, crypto and any other financial instrument.

As we mentioned in our first Edu series episode, Diversification means mixing a wide variety of investments in a portfolio. Diversification (if it's done well) reduces the total portfolio risk by allocating assets to financial instruments that would react differently to the same market events

Once you plan a diversification strategy, you should consider that you cannot mitigate all the risks, thus is essential to understand which risks you could diversify and which you cannot.

 

Which risks you can mitigate

When we talk about diversifiable risk (also known as non-systematic, or unsystematic risk), we mean company-specific risk that impacts the price of that individual share. Some examples of unsystematic risk are (and this list is not by any means exhaustive):

  • Changes in business operations:

Internal as well as external issues can cause business risk. The internal risks are related to the operational efficiency of the business. For example, when the administration fails to obtain a patent to protect a new product that could become a risk if a competitor steals the intellectual property. Or, operational risk may be caused by unforeseen events such as a technological failure in hardware or software.

  • Management practices:

This type of risk is associated with the type of leadership within a company and could include issues with company's management capacity, the level of business indebtedness, or specific labor strikes, which do not affect the market in general but impact on individual companies.

  • Specific legal/fiscal policies:

This type of risk is associated with the change in laws and regulations that affect a business or industry since these changes can usually increase operating costs, making it difficult for the company to operate.

 

What type of risks you cannot mitigate?

A risk that you cannot mitigate is also known as systematic risk, which means a risk associated with the entire market. That is different from non-systematic risk, which is more associated with a specific industry or segment.

The first thing we need to know is that systematic risk is uncontrollable since it is caused by external factors that affect the markets due to unexpected global events such as wars, financial crises and health crises. During financial crises such as GFC or Covid pandemic, all stocks markets suffered and therefore most of the listed securities took a dive. It usually takes some time until the securities start to recover, and the speed of recovery (if any) will largely depend on the strength of the company issuing those securities or those financial instruments.

 

Diversifying your investment portfolio helps you to mitigate your risk. How do you do it ??

Some types of assets are riskier than others. For example, stocks are more volatile than bonds because there is a significant risk that if the company fails (due to any of the risks listed above, or others), the shareholder's investments will decrease, potentially to the point that all initial investment will be lost. Stocks are certainly more volatile than cash, and at the same time stocks are usually less volatile than cryptocurrency. Examples could continue.

Therefore, a well-diversified portfolio will be much more robust in front of inherent market volatility than a focused portfolio, since different assets types would respond differently to the same market conditions. That is, they are not correlated or they are negatively correlated.

The correlation coefficient between any two investments is calculated using historical data (in Diversiview it is calculated based on 10 years of historical returns) and it comes up as a value between -1 and 1. The strongest correlations between two investments is 1 (perfect positive correlation) when the prices move together, up or down, at the same time and with the same intensity. A value of 0 indicates that there is no correlations between those two investments (they move independently),  while a value of -1 indicate a perfect negative correlation (when the prices move oppositely at any given time; i.e. one goes up and one goes down at the same time and with same intensity).

Note that is critical to look at the level of correlations between pairs of individual investments. We cannot just assume that by spreading the investments across a number of asset types or industry groups, the same level of diversification would be achieved. That is simply because any two companies/stocks from two different industry groups or asset types classes would have their own correlation value, different from other companies/stocks from the same two industry groups or asset types classes. Therefore, the level of portfolio diversification (and, in turn, the total portfolio risk) will be different.

Example of why high level diversification is not sufficient:

Let's consider a portfolio of investments spread across 5 industry groups as in Fig1 below.

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                            Figure 1: Example portfolio spread across 5 industry groups 

Does this mean that two people invested in those 5 industry groups would achieve the same level of diversification? For example, let's assume two portfolios as below. 

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Figure 2: Example of two different portfolios across the 5 industry groups in Fig1

Is this a case of "same industry groups, same diversification"? 

The answer is No - because the stocks have different levels of correlations, which means the total diversification would be different, as shown in Fig 3 below.

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    Figure 3: Individual correlations for example portfolios in Fig2

In conclusion, you need to be very careful about not relying on high level diversification information only.  It would be incomplete and it will impact on how your portfolio risk is calculated. Only knowing the real, granular diversification at investment level will help you get a correct perspective of your portfolio diversification.

 

"The correlations between pairs of securities are critical in calculating portfolio risk meaning that the diversification goal was achieved". 

The best diversification is achieved when as many correlations as possible are very low (close to zero) or negative.

 

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Laura Rusu

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Disclaimer: LENSELLDiversiview® is a trademark of LENSELL GROUP PTY LTD. LENSELL accepts no responsibility for any claim, loss or damage as a result of using the information on this website. The website content is provided "as is" for information purposes only, it should not be considered financial advice nor solely relied upon for making any trading decisions. Please consult a finance professional before buying or selling any securities or before making any other changes to your portfolio.